17 July 2009

The origin of the financial crisis: an iconoclastic view (1)

In a previous post, I commented on Goldman Sachs Q2 2009 profits and bonuses. I heard and read almost everything about the origin of the crisis and how to resolve it. I am not going back to silly comments like the one of Nicolas Sarkozy who, in October last year, identified tax havens as one of the two causes of the financial crisis, relayed soon afterward by many politicians, particularly in over indebted countries (curious isn't it?); unfortunately a wrong analysis of the causes of the crisis will lead to the wrong solutions. Let's reviex the origin of the crisis as I perceives it (this is largely extracted from a paper I wrote in French in December 2008).

1. Monetary expansion and indebtedness

Since Alan Greenspan took over the helm of the FED
from Paul Volcker, and in particular since October 20, 1987, money has been flowing at will (with some restraints from time to time). The FED has pursued a cyclical monetary policy whilst policy makers did not engaged into structural reforms. Interest rates remained abnormally low thanks to the transfer of large chunks of the industry into low cost producing countries in the 1990's, phenomenon that accelerated in the 2000s, whilst developed world companies became so-called platform companies. This in turn had a deflationary effect, allowing developed countries to display low inflation rate (whether I believe official statistics is an other matter - have a look at Shadow Government Statistics - but the phenomenon was there anyway).

This lax monetary policy had three consequences:

  • Government around the world could borrow cheaply and continue to see their sovereign debt grow
  • Corporate had no problem to access borrowing to pay for a-never-seen-before flurry of takeover bids, as well as hedge funds and other that could easily leverage (over-leverage)
  • Consumers could buy on credit many consumer goods (even at prohibitive interest rates) and not the least real estate, and think they were wealthy
This coupled with the blind belief in the modern portfolio theory and all the statistical/probabilist based models led people to ignore the reality of the human factor (I recommend everybody to read books written by Nassim Nicholas Taleb "Fooled by the randomness - the hidden role of chance" and "The black swan").

Everybody was happy and... shortsighted. The rare voices that expressed their concerns were rapidly silenced (consumers/electors prefer to listen to the free lunch story). Politicians continued in numerous countries to encourage people (with may incentives) to become owners of their home and banks to lend with total disrespect to the reality of life and credit risk.

This had a two side-effects:

  • Enriching some developing countries (China in particular) whilst impoverishing the Western world (like for any corporation, to know your real wealth at any time, you have to substract net debt).
  • A rapid change in the world balance of power from the West to the East, from democracy to authoritarian regimes. This will have tremendous consequences in term of imposing an agenda (environment, etc.) and access to commodities and energy (Chinese don't care about human rights, hence their successes in ensuring long term supply of natural resources in many underdeveloped countries).

So, all economic and policy makers took advantage of a situation that led to over indebtedness without Governments undertaking any fundamental/structural reform aiming at reducing this debt and preparing the future for our children and grand children (among world leaders, Thatcher is probably one of the few exceptions). Look at the state of the social security and retirement benefits in all developed countries: dismay!

The financial crisis is the brutal adjustment to this situation.

The second part of this paper will review Competence, Governance and Ethics.